As we’ve mentioned, many of the fees and costs that private equity investors bear are hidden from them by virtue of being shifted to the portfolio companies. For instance, private equity firms charge what Oxford professor Ludovic Phalippou has called “money for nothing” or “monitoring fees.” Many also charge “transaction fees” on top of the large fees they pay to investment bankers for buying and selling companies. The reason that those charges are opaque to private equity limited partners is that they have no right to see the books and records of the investee companies.

But surely limited partners like private equity investor heavyweight CalPERS know what they are paying in contractually specified fees, namely the annual management fee and the so-called carried interest fee, which is a profit share (usually 20%) which usually kicks in after a hurdle rate (historically, 8%) has been met, right?

Think again. Private equity firms simply remit whatever they realize upon the sale of a company, net all those lovely fees and expenses (which include hefty legal fees) and any carry fee they think they think they are entitled to take.

Put it this way: If you were selling your house, would you hire a firm to provide a turnkey service (spruce up the house, negotiate the sale with a buyer, and take care of all the closing costs) and not demand an accounting of the gross price and what was deducted to arrive at your net proceeds? Yet it’s standard practice all across the industry for private equity investors simply to receive distributions with no explanation at all.

See the discussion from the investment committee section of the CalPERS board meeting. The presentation on cost management starts at 1 hour 55 minutes, and the section on carried interest begins at 2 hours 6 minutes, and the CalPERS staff member making the presentation is Wylie Tollette, Chief Operating Investment Officer.

Amusingly, Tollette starts his talk by referring to one of CalPERS’ investment principles, “Costs matter and need to be effectively managed.” You’ll see shortly how CalPERS is in flagrant violation of its own lofty beliefs.

Tollette discusses how CalPERS implemented a cost reduction effort in 2007 and the recent results on metrics the staff has defined as important. Board member JJ Jelincic leads off the questions at 2:06 (emphasis ours):

Jelincic: The external management fee, profit sharing line, second one down, that does not include private equity.

Tollette: That’s correct. That does not include private equity. That includes real estate and ARS for the Absolute Return Strategy, which was fully in effect through the fiscal years in question, and a few that exist in the Global Equity Program.

Profit sharing in the private equity market, in fact the whole private equity industry, it’s embedded in the return. It’s not explicitly disclosed or accounted for. We can’t track it today. That’s — as you know, that’s part of the effort around the PEARS project, which I’m going to touch on in a few slides, as well as requiring additional disclosure by the private equity managers in order to track incentive fees in the same way that we can across the other asset classes.

Jelincic: But if you can’t track them, they’re kind of hard to manage, and that kind of goes to costs matter and goes to the fact that we’re current on the fees.

Tollette: They — it’s an industry challenge in the private equity space, where the fees that — the carried interest or the profit sharing fees that are accrued and retained by the management firm, that’s not just a CalPERS issue, that’s an industry issue. And we’re trying to put in place the tools, so that we can have better disclosure and understanding of what they are.

Understand what is going on here. Tollette is trying to blunt Jelincic’s questions by saying that CalPERS is getting a new computer system in place that will have the data fields that will enable staff to capture these fees. That’s an admission that the information service that CalPERS used and much of the industry still uses, Private Edge, didn’t even attempt to capture this information. Why have empty fields for information you don’t get? So Tollette is acting as if having the ability to record the data someday, down the road, is tantamount to actually getting it. There’s no reason to think that the general partners will provide this information unless CalPERS starts demanding it in negotiations when it invests in funds. We’ve seen nothing in the private equity industry press reports or CalPERS board presentations to suggest that CalPERS has even tried to negotiate these changes, much the less had any success.

And these omissions are material. Jelincic again, at 2:20:30:

Jelincic: It’s not even disclosure. It’s not knowing. It’s really hard to figure out what we are paying in carry. My guess for that year, based on tidbits here and there, is a rather narrow range of somewhere between 600 and 900 million dollars, which is at least twelve times what we are paying staff for the total fund. It’s a big number, and we don’t really know what we are paying, and I find that frustrating.

We’ve found it hard to convey how badly captured limited partners are, and this example hopefully provides a sufficiently vivid illustration. Here, CalPERS, supposedly the most seasoned and savvy investor in private equity, is flying blind on how much it pays in carry, while going through the empty exercise of meticulously tracking its woefully incomplete tally of visible charges. This is a garbage in, garbage out exercise as far as private equity is concerned. Moreover PE real (as opposed to visible) fees and costs are so high that CalPERS’ claims about its fees and costs across its entire portfolio are rubbish.

Let us put it another way: If you found an aged parent had given money to a fund manager who had the same degree of latitude that private equity firms have to charge fees and expenses and not account for them, you’d not only seek to get the money back from that manager as quickly as possible, you’d seek to take that parent’s checkbook away because they were obviously incapable of managing their investments responsibly. Yet the same sort of recklessly trusting conduct is accepted as perfectly normal by major fiduciaries. Time for state legislatures to wake up, smell the coffee, and start asking some tough questions.

Post navigation

44 comments

Thank you for this and the whole series on PE fees and behavior – the articles are important and very instructive.

As a side note, the guy’s name appears to be Tollette rather than Toilette (spell checker mishap or your opinion of the guy? (-: ) If his name had been Wylie Toilette that would have been a man who had triumphed against impossible odds.

I vote for the Toilette spelling. Because yields are in the toilet. clearly. This is an analysis of the unspoken obfuscation of the expenses of not really surviving versus the expenses of thriving. So if it isn’t really there in clear terms, well…it isn’t there at all. So this is double dipping as far as the IRS is concerned for various expense exemptions and etc. boondoggle. It’s an IRS issue, but the IRS doesn’t have the incentive to call BS on the language.

That’s hilarious the management team claims costs matter and then invests in PE.

I tend to think costs are overemphasized as a general issue (relative to the matter of how the underlying capital is invested), but when you put the issue out there as a management team and fail to deliver upon it, that is about as blatant as negligence and willful failure to carry out one’s fiduciary duty as it gets.

I’m curious Yves if you have heard (on or off the record) from lawyers interested in actually going after pension management, either regulators (ha) or private practice?

‘I tend to think costs are overemphasized as a general issue (relative to the matter of how the underlying capital is invested.’

Expected real returns on fixed income are about 2 percent. Traditionally, equity investors have expected 5 or 6 percent real return. But at current high valuations, an equity real return of only 2 percent for the next decade would not be surprising.

At 2 percent real return, any cost above the 0.1% that a competitive S&P 500 index fund charges is a serious drag on performance. How can pirate equity and hedge funds (famous for their 2% of assets plus 20% of profits model) keep up? They can’t.

During bull markets, leverage provides the illusion that their returns are competitive with publicly traded equity. But in the inevitable recession and bear market that follows, leveraged players get carried out feet first. In the next bust, which I have penciled in for 2017, pirate equity and its public pension fund victims are going to get smacked silly.

What to do, what to do? You know the drill — raise taxes on innocent bystanders!

2017?!? Really? I would think it would be coming a lot sooner than that, but I’ll take your educated guess over my own any day. Does this mean I still have time to cash in on this foundation-less bull market? Do I still have time to buy in and find a greater fool to cash me out? I thought I’d missed that opportunity already…

Recessions are more common in the first two years of presidential terms than in the last two. The election year of 2008, with its economic and financial meltdown, was a major and unusual exception.

But for long range planning purposes, assuming a 2017 recession should be slightly better than a random guess. It’s rather late in the cycle to pile into stocks. But it might be a good time to bail out of real estate, while the propaganda news feed is still claiming that every day, in every way, we’re getting richer and richer.

Which of course is why at an aggregate level we’ve been doing money printing instead of taxation. The innocent bystanders have little wealth left to tax, and heaven forbid we tax the non-innocent.

That’s why the fee focus has become of interest to me. It’s an obvious micro area where the management is throwing away money because it gives them personal goodies like rubbing elbows with influential people and career advancement and sounding smart and making significantly higher wages than average workers and so forth.

But systemically, we’ve hit some sort of inflection point there somewhere between media consolidation and Enron and Bear Stearns where there just isn’t enough actual real world investment in productive output to support the inequality of highly compensated public employees even if the pension funds were paying nothing in fees. It’s not about broad asset allocation or eliminating the worst behavior of PE and related fraudsters at this point. There just aren’t enough financial returns period to pay for the outsized privileges of the police state and higher ed and healthcare and all the rest.

When you build prisons instead of houses, guess what, associate prison wardens still want a house. A pretty nice one, of course. And the chief deputy warden better get an even nicerer one.

CalPERS has about 2,700 employees to take care of 587,000 beneficiaries. 217 beneficiaries per worker.
SSA has about 60,000 employees to take care of about 59,000,000 beneficiaries. That’s 983 beneficiaries per worker.

Yet despite being much more inefficiently run, CalPERS has dozens of employees making more money than the top officials at SSA.

Huh? Costs and expenses matter a great deal. The drag that costs have on returns is why indexing has become so popular. Active managers don’t earn back the extra costs of their higher fees in performance.

And the real issue is if the full costs of PE were known, it would become too obvious that it’s an exercise in strip-mining companies. Ludovic Phalippou of Oxford estimates the full costs at 7% per year.

For costs being overemphasized, I don’t mean underlying assets as in a tweak to the asset allocation model. I mean the more fundamental task of allocating resources.

Public pensions are invested in the same inequality-producing, car-dependent, oil-using, financial fraudster assets as everybody else. It’s not any one person’s fault; it is a systemic problem.

I agree PE fees are ridiculous. Which is why I’ve come to the conclusion that a very easy test of corruption is whether a public manager invests anything at all with them. But the systemic observation is that even reducing these fees to zero doesn’t make huge payouts to some retired workers sustainable when other workers who are still working are barely surviving.

At least there is an admission here, on the record, that they have no idea what they’re paying. News out of Rhode Island is that there needs to be more detail produced for the public to understand what the fees really are with PE. If the pressure keeps up, we might actually see real reform in the industry.

I don’t really understand that complaint. On a PE K1, you should be able to just look at the ownership percentages. If an investor has a higher profits interest % than their capital account %, they’ve got a carried interest.

Don’t hold your breath. The general partners are dead-set against letting either the limited partners or the public know these internal fees. It would be tantamount to bank robbers letting the banks know who’s next.

Time for state legislatures to wake up, smell the coffee, and start asking some tough questions.

Methinks your state legislators are going to need some encouragement before they get serious about this. I think it’s time for PENSIONERS to start asking some tough questions of their legislators and fund-managers: “why have you been derelict in your fiduciary duties?” “what gives you the right to play so fast and loose with MY retirement savings?” “why aren’t you working for a PE firm instead of a pension-fund, since that’s obviously where your loyalties lay?” “Which do you prefer, noose or guillotine?” (just kidding about that last one, swear)

People, this is YOUR money. They are looting YOUR savings. Yves has shown us how. Get pissed off, get loud, and let your legislators and your pension fund managers know. Hold their feet to the fire. Call them at work. Call them at home. Harass the bejeezus out of them until they are FORCED to do the right thing or resign in shame.

The article left me with an obvious question: Isn’t “Toilette” in deep trouble here? His verbal stumbling around indicates that he thinks so. So did Jelincic (that spelling proved variable, too, but who’s counting?) move that they fire his ass?

What this all too clearly lays out is that on top of everything else that there is a total breakdown of fiduciary responsibility.

I suspect that if one could collect the data, without expending humongous effort, that due to the lure of hobnobbing with “Wall Street Very Serious People”, political patronage despite pay-to-play laws (example what is documented to happen in NJ), copycat-ism, the enabling of bad behavior by the pension consultants, etc. that there has huge growth in these fees by public pensions. None of which have produced the promised returns, while perversely hurting economic and job growth in the many of the states providing the funds their lifeblood.

This is almost all occurring unseen by the public, by the beneficiaries, etc.

“Hey, everybody else was doing it too, and besides, those Pirate Equity guys had real nice suits…so they must know what they’re doing, right? Also, I had a Nobel-winning economist assure me that fraud can’t exist in markets, so how could I have knowed that those Pirate Equity guys would turn out to be fibbers? It’s like they don’t know about the efficient market hypothesis or something.”

An honest question: to what extent are pensions and other such funds constrained into investing with private equity? Is there a quantum of other financial products available that they could, to use a potentially silly example, simply put all the money in index funds? I ask, because I wonder whether pressuring pensions simply to divest might be an effective strategy for breaking private equity or, at least, get pe firms to behave better and more transparently. I’d like to think that if CalPERS or any of the other state pension funds threatened to take their money and go somewhere else that we’d see a marked change in behavior.

I don’t understand why state pension funds don’t keep most of their investments in-state. Especially a state as large as CA. It’s classic fiscal stimulus, and it would be far easier to monitor prospects.

Years ago, PERS, the Oregon fund, lost a bundle in a real estate deal….in LONDON. Why were they investing in London? What made them think they wouldn’t get scammed? Close to home, at least they know the players and they have legal recourse.

There has been discussion about CalPERS divesting PE investments, but I was doubtful if that had happened. Clearly PE is the big scam du jour, and yes, they’re playing with MY money – and that of many many unsuspecting CA pensioners (or wannabe pensioners).

I will pass this info on to others, fwiw.

Thanks again and keep up the good work. Much appreciated.

Sign me,
Hard working Californian forced to invest in CalPERS. What ARE you doing with MY hard earned money???? Divest from PE ASAP.

PS I know some IT/software engineer people who were, at one time, working on either improving or replacing the CalPERS Investment software system. They were working on this over 10 years ago. And so there you go, CalPERS has still somehow not managed to capture the PE costs of investment. Again, as a CalPERS investor and CA taxpayer, what am I getting for my money?

The CalPERS board cannot see the Pickpocket Equity, er, Private Equity costs. But they are told by PE and apparently believe that the costs are fine, just fine. And the end product, the returns, they are assured are extraordinarily beautiful. Everybody says so. Although they can’t really tell since they can’t see the costs.
Why does this sound like the children’s story “The Emperor’s New Clothes”?

Besides limitations on maximum portfolio allocations, why doesn’t CalPERS board (and their fellow travelers in other states) simply pass a resolution that going forward the pension fund will no longer invest in any private equity limited partnerships that fail to agree to disclose all private equity carry fees, including those passed through to “portfolio companies”, on a full and timely basis and that those fees remain within pre-defined cost parameters?

Further, although I have not watched the linked video of the CalPERS Investment Committee Meeting of April 13, 2015, I recall from a previous video of a CalPERS meeting regarding selection and approval of outside consultants to assess private equity firms and specific transactions, that this topic was raised. Whatever happened regarding the fiduciary responsibility of those “independent consultants” in this matter?

My own subjective feelings about state employees pension funds investing in leveraged buyouts by private equity firms is that actions taken in the wake of many of these LBO transactions have damaged the acquired companies and their employees. So I question whether any state employees’ pension funds should be investing in this space in any event.

As a CalPERS investor and future annuitant, thank you for sunshining the private equity trap — and thanks to JJ Jelincic for asking the tough questions. CalPERS will always of necessity be run by political appointees, but transparency is how they can be forced to act as fiduciaries rather than as rentiers. CalPERS investment managers live in the same ZIRP world as everyone else, and are just as tempted as all the other “dumb money” to chase promises of high returns without asking the tough questions and requiring full disclosure. The private equity industry has become nothing more than a confidence game, but Fed policy and deregulation have corrupted all the markets in which our retirement savings must be invested.

I’m typically only one to express an opinion on the Internet when there’s something to snark about or a target to troll, but in light of Yves’ encouragement of commenting on the more finance-y articles, here goes…

I’m reminded of older posts about the shortcomings of “IRR” as a performance metric and the extent to which it can be gamed. With that in mind — and speaking as an Efficient Markets kind of guy (in theory) — it’s a priori that where there is an opportunity to profit in the market those opportunities will be chased after (much like 10 year olds chasing after a soccer ball in tandem). At the same time, regulation of this “chase” is less a deterrent in itself than it is a factor that is blended into the quantified and purportedly return-commensurate level of risk. In other words, regulated practices are filtered as: is the risk of getting caught breaking the law worth taking? By this logic — as opposed to one grounded in more ethical considerations — above a certain threshold of expected value, the law will be broken. Does this type of mathematically justified incentive to transgress exist between the general and limited partners of the types of “alternative investment funds” of which CalPERS is so fond?

Intuitively: if the fund does great then you have great results to show your investors, but if the fund does bad can you show them not-bad-but-okay results? I mean, these guys do wield a lot of capital, enough that with the miracles of financial engineering you can redirect a cash flow here, depreciate there, mark it to the (supposedly persistently rising) market…simply ask Lehman Brothers’ former accountant how easy it is to put lipstick on a big fat greedy pig. Indeed, this is not to say that PE is one big Ponzi scheme. Having said that, by the logic of efficient markets (and, of course, history) the leeway that is vouchsafed by malleable performance metrics like IRR and the extent to which the lack of transparency is all but legally protected, the utility of Ponzi finance would seem to be one way to conceal losses or exaggerate gains if the GP’s were so inclined. (Does this happen? I don’t know! But alas, markets being efficient, once you or I could ascertain that it does it would already be a “standard industry practice”.)

It’s hard to get that worked up about seemingly “victimless” fraud, this being America and whatnot, but it is kinda scary in light of the extent to which credit and liquidity risk has been shifted from banks to “shadow banks” (now a standard line of business among the largest PE players). A story as old as the Roman Empire: markets go up and they go down. Needless to say, the determinism of bear markets doesn’t account for systemic failures like what we saw in 08. After all, it wasn’t just the failure of the housing market, but the systemic fraudulent concealment of risk which, far from being commensurate with the maximally leveraged returns, unhinged the system at its fulcrum and made everything topple down.

Sadly, one thing as common as Wall Street’s poor institutional memory is that Main Street always gets reamed: last week it was the savers, yesterday it was the homeowners, tomorrow it’ll be the pensioners. (How is your CalPERS suit going by the way?)

2. PE fund performance used to persist, as in it used to be true that top quartile funds stayed top quartile funds. No longer.

3. PE funds raise new funds 4-5 years after their last fund. So investors look at the most recent funds as a proxy for who is good. However, PE firms sell their best deals early, so the returns early in a fund’s life don’t necessarily predict performance. One fund, for instance, showed a 77% IRR in its early years based on a blockbuster early deal. The eventual returns for the entire fund? 11%.

They are supposed to outperform public stocks by 300 to 400 basis points due to the illiquidity risk. Public pension funds often use the S&P as a benchmark, which gives PE a break it does not deserve, since S&P 500 companies are MUCH bigger (and hence natively slower growing) than the size of PE portfolio companies.

Even with its supposedly greater savvy and access. PE has not met CalPERS return benchmarks over the last 10, 5, 3, and one years.

These excerpts from the CalPERS board meeting sound like bad Kabuki to me. I don’t believe Tollette’s report was news to anyone in that meeting. This is 2015. Can anyone attending this meeting honestly claim surprise at what they heard?

Who are these guys and why are still sitting in seats of authority? Doesn’t responsibility go with that authority — responsibility to the pensioners and future pensioners counting on the CalPERS fund for their retirement? I do not understand.

Another matter — the evident corruption in the CalPERS board is one thing — it is my impression much of this bad drama results from the State of California’s deliberate underfunding of the state pension funds. Isn’t the CalPERS effort toward higher yields — even “supposed” higher yields as in the case of private equity funds — part of a larger game?

Been reading these PE posts with interest. Starting some work on EIS in the UK and seeing many of the same issues/strategies being used. Products are marketed as no fee to investors, when the companies are paying multiple fees to managers. But retail investors are seduced by tax breaks and can’t quantify what is at best vaguely disclosed. Same tricks, only slightly different context.